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The CROWDFUND Act: everything you need to know

Yesterday, United States President Barack Obama signed into law the JOBS Act, which may be the most significant update to securities regulations since Sarbanes–Oxley was passed in 2002.

One portion of the new law, the CROWDFUND Act, has been creating a lot of buzz in Silicon Valley for months, as it will make it legal for startups the ability to raise money in small chunks from large numbers of non-accredited investors.

The CROWDFUND Act has plenty of supporters who believe crowdfunding could revolutionize startup investing. Skeptics argue that crowdfunding will have unintended consequences, from fraud to a bubble of epic proportions.

So who is right? Unfortunately, few of the articles and blog posts about the CROWDFUND Act appear to be written by individuals who have taken the time to read its text. As such, much of the discussion around the future of crowdfunding and the impact it will have is ill-informed.

So what does the CROWDFUND Act really say, and what does that mean for the startup ecosystem? Here’s what you need to know.

The Details

Funding Portals

Not surprisingly, a whole host of companies have popped up in recent months and weeks seeking to cash in on the crowdfunding craze. Many of them are positioning themselves to be Kickstarter-like intermediaries, connecting companies and investors, taking a cut of the action in the process.

The CROWDFUND Act requires that these so-called ‘funding portals’ register with the SEC through one of multiple means, and burdens them with certain obligations. Those include implementing procedures to reduce fraud, such as performing background checks on company directors and executives, and making sure that investors don’t invest more than they’re permitted to under the law.

Beyond the obligations the newly-enacted legislation explicitly spells out, the CROWDFUND Act tasks the SEC with establishing more detailed rules for funding portals — rules that these portals will be required to comply with.

What you need to know

There are certainly going to be interesting opportunities for crowdfunding portals, but far too many are jumping the gun in an effort to get into this nascent space. It’s not clear that many of the wannabe intermediaries launching websites will actually have the financial and legal resources to register as funding portals under the CROWDFUND Act.

As many of the rules and regulations around funding portals won’t be known for months, entrepreneurs interested in raising money through crowdfunding and investors interested in buying shares in crowdfunded startups should probably take a wait and see approach before getting involved with any company claiming it’s going to be a funding portal.

Disclosure Requirements

All companies seeking to raise money will need to disclose certain information, such as the legal status of the company, the names of directors and officers, a description of how the funds raised will be used, how the price of the company’s stock was determined, the company’s capital structure, and legal terms associated with the securities being sold.

Additional information will be required based on the amount of money a company is looking to raise:

A company seeking $100,000 or less will have to provide an income tax return for the most recently completed year (if any) as well as financial statements which are “certified by the principal executive officer…to be true and complete in all material respects.”

A company seeking $100,001 to $500,000 must provide financial statements that have been reviewed by an independent public accountant in accordance with “professional standards and procedures” or specific procedures that the SEC establishes specifically for this purpose.

A company seeking more than $500,000 are required to provide audited financial statements.

Every year, all companies will be required to provide to their investors “reports of the results of operations and financial statements of the issuer, as the [SEC] shall, by rule, determine appropriate” and if that’s not enough, companies will need to “comply with such other requirements as the [SEC] may, by rule, prescribe, for the protection of investors and in the public interest.” That, of course, leaves the door wide open for the SEC to clamp down if fraud becomes a problem.

Needless to say, companies will incur costs in complying with all of the above. An attorney will reasonably be required to put together the initial paperwork. CPA firms can charge thousands of dollars to review financial statements and audited financial statements often cost upwards of $10,000 to produce. For companies raising $100,000 or less, the financial disclosure requirements are less onerous, but it’s worth considering that a chief executive with good judgment will be hesitant to certify that her financial statements are “true and complete in all material respects” without the involvement of a CPA.

What you need to know

There’s no such thing as a free lunch and the CROWDFUND Act isn’t going to change that. Raising money through crowdfunding and keeping up with compliance will require both time and money.

Based on the requirements spelled out in the CROWDFUND Act, companies hoping to raise money should probably be prepared to spend tens of thousands of dollars on attorneys and accountants, making them the two parties which may stand to gain the most from this law.

Liability

Crowdfunding will give entrepreneurs and owners of existing businesses a new means of raising capital, but it doesn’t come without risk. Under the JOBS Act, investors can bring suit against a company they’ve invested in for material misstatements and omissions. Liability extends to the company’s directors and principal officers, so individuals at the helm of crowdfunded companies will be taking on a significant amount of responsibility when they accept investment.

What you need to know

It didn’t take the lawyers long to pounce on Groupon when it made an accounting blunder and crowdfunded startups shouldn’t expect attorneys to give them a free pass either. Keeping the Is dotted and the Ts crossed is going to be a must for crowdfunded companies, and inexperienced business owners and those who skimp on competent legal and accounting counsel could easily find themselves facing financial ruin at the hands of their own investors.

Investor Restrictions

The investment limits placed on individuals have been widely discussed, but individuals considering participating in crowdfunding should also be aware of the less talked about restrictions that will apply to the securities they purchase.

The most important: securities purchased through a crowdfunded offering cannot be sold or transferred for one year unless they are sold back to the issuing company, an accredited investor, a family member or as part of a registered offering. In other words, crowdfunded investments are likely to be illiquid for at least one year from the date on which they’re purchased.

What you need to know

Dumping a stock that you’ve fallen out of love with or that’s plummeting in value is generally easy when the stock is publicly traded, but investors will find little room for buyer’s remorse once they put money into a crowdfunded company. In a worst case scenario, investors may have no way to exit an investment before it loses most or all of its value.

Key Takeaways

So where does all of this leave crowdfunding? There are four important takeaways interested parties should take away from the CROWDFUND Act.

Regulations are dead, long live regulations.

Regulations that once prevented companies from raising capital from non-accredited investors through public channels are going away, but that doesn’t mean that the regulations the CROWDFUND Act creates are trivial. Funding portals and companies alike will still have plenty of rules to comply with. In the end, those rules may not be sufficient enough to prevent the fraud some are worried about, but they will require those wishing to participate in the crowdfunding ecosystem to jump through more than a few hoops.

It will take money to raise money with crowdfunding.

Starving entrepreneurs looking for an easy way to fund their dreams will probably be disappointed by crowdfunding. With the disclosure rules mandated by the CROWDFUND Act, it’s hard to see an entrepreneur or business owner getting an offering off the ground with less than a five-figure investment.

What’s more: there’s no guarantee that the investment will pay off, as the CROWDFUND Act requires that an offering reach a certain threshold of investor commitments before would-be investors are obligated to put their money up. That means some companies could actually lose money when they prepare offerings that aren’t successful.

There may be fewer investment opportunities than expected.

There can be little doubt that some companies will turn to crowdfunding to raise capital, but the time and money required to comply with the CROWDFUND Act may mean that far fewer opt to go the crowdfunding route than crowdfunding’s supports expect.

Technology startups may have a tough time.

Much of the discussion around the crowdfunding portion of the JOBS Act centers on the law’s impact on technology startups. But it’s not clear that the attention is well-placed.

Technology startups with traction or an experienced management team typically don’t have a problem raising funding today, particularly in Silicon Valley. On the flip side of the coin, it’s questionable as to whether idea-stage startups without revenue, traction and an experienced management team will be able to muster up the money, paperwork and interest required to get a crowdfunded offering off the ground.

With this in mind, there’s a strong argument to be made that the companies most likely to stand out in the crowdfunding crowd will be established small businesses with some traction and a plausible need for expansion capital.

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